Tag Archives: Value Investing

10 Powerful Lessons from The Little Book That Still Beats the Market

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Here are 10 powerful lessons you might glean from Joel Greenblatt’s The Little Book That Still Beats the Market:

Value Investing Strategies

1. Focus on Quality and Bargains: The book champions value investing, where you buy stocks of high-quality companies at a discount to their intrinsic worth.

2. The Magic Formula: Greenblatt introduces his “Magic Formula,” a ranking system that identifies stocks with good earnings yield (earnings per share divided by share price) and high return on capital (a measure of profitability).

3. Simple Yet Effective: The Magic Formula is a straightforward approach that can be applied by investors of all levels of experience.

4. Long-Term Investment Horizon: The book emphasizes a long-term investment approach, focusing on holding stocks for several years to benefit from company growth.

Disciplined Investing Practices

5. Diversification: While the Magic Formula helps identify undervalued stocks, The Little Book That Still Beats the Market also emphasizes diversification to spread risk across different companies and sectors.

6. Patience and Emotional Control: Value investing requires patience and discipline. The book discourages reacting to market fluctuations and encourages sticking to your investment plan.

7. Low-Cost Investing: Greenblatt advocates for minimizing investment fees and expenses to maximize your returns.

Value Investing Philosophy

8. Margin of Safety: The book emphasizes the importance of buying stocks with a “margin of safety,” meaning the price you pay is significantly lower than the company’s intrinsic value.

9. Thinking Like a Business Owner: Value investors approach the stock market as buying ownership in businesses, not just trading pieces of paper.

10. Beating the Market, Not Timing It: The book focuses on building wealth through a long-term value investing strategy, not attempting to time the market.

Additionally

• Greenblatt’s approach has been successful for him and some investors, but past performance is not a guarantee of future results.

• The book offers a clear and concise introduction to value investing principles.

By reading The Little Book That Still Beats the Market, you can gain valuable insights into value investing strategies, understand the Magic Formula, and develop a disciplined approach to building wealth through the stock market. Remember, investing involves inherent risks, so it’s crucial to do your own research and understand your risk tolerance before making any investment decisions.

BOOK:https://amzn.to/4d8bD0Q

You can also get the audio book for FREE using the same link. Use the link to register for the audio book on Audible and start enjoying.

Value vs Growth Stocks

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Value investors want to buy stocks for less than they’re worth. If you could buy $100 bills for $80, wouldn’t you do so? ~ Motley Fool

Most public equity stocks are classified as either value stocks or growth stocks. Generally speaking:

  • A value stock trades for a cheaper price than its financial performance and fundamentals suggest it’s worth.
  • A growth stock is a stock in a company expected to deliver above-average returns compared to its industry peers or the overall stock market.

Value stocks generally have the following characteristics:

  • They typically are mature businesses.
  • They have steady (but not spectacular) growth rates.
  • They report relatively stable revenues and earnings.
  • Most value stocks pay dividends, although this isn’t a set-in-stone rule.

Growth stocks generally have the following characteristics:

  • They increase their revenue and earnings at a faster rate than the average business in their industry or the market as a whole.
  • They developed an innovative product or service that is gaining share in existing markets, entering new markets, or even creating entirely new industries.
  • They grow faster than average for long periods tend to be rewarded by the market, delivering handsome returns to shareholders in the process.

Regardless of the category of a stock, economic downturns present an opportunity for a value investor. The goal of value investing is to scoop up shares at a discount, and the best time to do so is when the entire stock market is on sale.

References:

  1. https://www.fool.com/investing/stock-market/types-of-stocks/value-stocks/
  2. https://www.fool.com/investing/stock-market/types-of-stocks/growth-stocks/

Berkshire-Hathaway Stock

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  • Berkshire Hathaway has beaten the S&P 500 going back 20 years.
  • The company is built to endure the most challenging market environments.

The “Oracle of Omaha” Warren Buffett is a legendary billionaire investor and one of the world’s wealthiest people. While his start at a very early age helped him build a fortune, Buffett hasn’t lost his investing touch.

Since becoming CEO in 1965, the Oracle of Omaha has overseen a greater than 4,400,000% return in his company’s Class A shares (BRK.A). This works out to a nearly 20% annualized return over 58 years.

Additionally, Berkshire Hathaway has outperformed the S&P 500 index over the past 20 years. Had you invested $10,000 in Berkshire Hathaway in 2003, you would have more than $71,000 today to the S&P 500’s $62,200.

Buffett, and his investing lieutenants, Ted Weschler and Todd Combs, are huge fans of businesses that regularly buy back their stock and increase Berkshire Hathaway’s ownership stake without him or his investment team having to lift a finger.

Stock buybacks can have a positive fundamental impact on a company. For a company with steady or growing net income, buybacks have the ability to increase earnings per share over time. This should help a company’s stock look even more attractive to fundamentally focused value seekers.

References:

  1. https://www.fool.com/premium/coverage/investing/2023/09/27/if-you-invested-10000-in-berkshire-hathaway-in-200/
  2. https://www.msn.com/en-us/money/topstocks/warren-buffett-is-selling-shares-of-this-high-yield-dividend-stock-and-likely-buying-shares-of-his-favorite-stock-no-not-apple/ar-AA1hkkk9

Successful Investor’s Psychological Mindset

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“Doing well with money isn’t necessarily about what you know. It’s about how you behave. And behavior is hard to teach, even to really smart people.” ~ Morgan Housel, The Psychology of Money

Individuals must understand that there is a psychological mindset that the successful investor tends to have.

The successful investor will focus on probabilities, intrinsic values and safety of margin while letting decisions be ruled by rational, as opposed to emotional, thinking.

Investors’ emotions are their worst enemy.

The psychology of money is the study of our behavior with money. Billionaire investor Warren Buffett contends that the key to overcoming emotions is being able to retain your belief in the fundamentals of the business, and not get too concerned about the stock market price.

Investors should realize that there is a certain psychological mindset that they should have if they want to be successful, and try to implement that mindset. Dave Ramsey has said that building wealth is “20% head knowledge and 80% behavior.”

Value investing mindset

Value investing derives the intrinsic value of a common stock independent of its market price. By using a company’s factors such as its free cash flow, earnings, return on invested capital, and dividend payouts, the intrinsic value of a stock can be found and compared to its market value. If the intrinsic value is more than the current price, the investor should buy and hold until a mean reversion occurs.

Mean reversion is the theory that over time, the market price and intrinsic price will converge towards each other until the stock price reflects its true value. By buying an undervalued stock, the investor is, in effect, paying less for it and should sell when the price is trading at its intrinsic worth. This effect of price convergence is only bound to happen in an efficient market.

The fundamental principle of value investments lies in the ability of the markets to eventually correct to their intrinsic values. Common stocks are not going to remain inflated or bottomed-out forever despite the emotions and irrationality of investors in the market.

References:

  1. https://www.investopedia.com/terms/b/bengraham.asp
  2. Morgan Housel, The Psychology of Money. Harriman House, Great Britain, September 8, 2020.
  3. https://www.amazon.com/gp/product/0857197681/ref=as_li_tl_nodl?

Contrarian Investing

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“The way to make money is to buy when blood is running in the streets.” ~ John D. Rockefeller

Contrarian investing believes that the worse things seem in the market, the better the investing opportunities are for profit.

Contrarians, as the name implies, try to do the opposite of the crowd. They get excited when an otherwise good company has a sharp but undeserved drop in share price. They swim against the current and assume the market is usually wrong at both its extreme lows and highs. The more prices swing, the more misguided they believe the rest of the market to be. (For more on this, read “Finding Profit In Troubled Stocks.”)

Bad Times Make for Good Buys

Contrarian investors have historically made their best investments during times of market turmoil. In the crash of 1987, the Dow dropped 22% in one day in the U.S. In the 1973-’74 bear market, the market lost 45% in about 22 months. The terrorist attacks of Sept. 11, 2001, also resulted in a major market drop. Those are times when contrarians found their best investments.

The 1973-’74 bear market gave Warren Buffett the opportunity to purchase a stake in the Washington Post Co. at a deep discount (the company could have “sold the [Post’s] assets for not less than $400 million.” Meanwhile, the Post had an $80 million market cap), an investment that has subsequently increased by more than 100 times the purchase price–that’s before dividends are included.

Sir John Templeton, founder of the Templeton Growth Fund, was also a serious contrarian investor, buying into countries and companies when, according to his principle, they hit the “point of maximum pessimism.”

As an example of this strategy, Templeton bought shares of every public European company at the outset of World War II in 1939, including many that were in bankruptcy. He did this with borrowed money. After four years, he sold the shares for a very large profit.

But there are risks to contrarian investing. While successful contrarian investors put big money on the line, swam against the current of common opinion and came out on top, they also did some serious research to ensure the investing herd was indeed wrong.

So, when a stock takes a nosedive, this doesn’t prompt a contrarian investor to put in an immediate buy order, but to find out what has driven the stock down and whether the drop in price is justified.

While successful contrarian investors have their own strategy for valuing potential investments, they all have the one strategy in common–they let the market bring the deals to them, rather than chasing after them.

References:

  1. https://www.forbes.com/2009/02/23/contrarian-markets-boeing-personal-finance_investopedia.html

Return on Invested Capital (ROIC)

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Return on invested capital, or ROIC, is a valuable financial ratio. Understanding ROIC and using it to screen for high ROIC stocks is a good way to focus on the highest-quality businesses.

Put simply, return on invested capital (ROIC) is a financial ratio that shows a company’s ability to allocate capital.

A high return on invested capital (ROIC) means investors are realizing strong returns on their investment in a company.

The higher the ROIC, the better a company is investing it’s capital to generate future growth and shareholder value.

For example, let’s say a management team had $1 million dollars to invest, and they could either invest in a new product line, or enhancements to their existing product line. After thinking it over, the Company invests the $1 million in a new product line. One year later, the Company looks back at what they have earned on the new product line, only to find out that it’s a measly $100,000.

As it turns out, if they had invested in the enhancements to their existing product line, they would have earned $500,000 over the same period of time. What does this mean?

Well, there could be more factors at play, but based on this example, the Company’s management team made the wrong decision.

As an investor, you want your management teams making the right decisions and investing in the areas that will generate the highest returns for you as an investor.
The common formula to calculate ROIC is to divide a company’s after-tax net operating profit, by the sum of its debt and equity capital.

Once the ROIC is calculated, it is evaluated against a company’s weighted average cost of capital, commonly referred to as WACC. If a company’s WACC is not immediately available, it can be calculated by taking a weighted average of the cost of a company’s debt and equity.

Cost of debt is calculated by averaging the yield to maturity for a company’s outstanding debt. This is fairly easy to find, as a publicly-traded company must report its debt obligations.

Cost of equity is typically calculated by using the capital asset pricing model, otherwise known as CAPM.

Once the WACC is calculated, it can be compared with the ROIC.

Investors want to see a company’s ROIC exceed its WACC. This indicates the underlying business is successfully investing its capital to generate a profitable return. In this way, the company is creating economic value.

Generally, stocks generating the highest ROIC are doing the best job of allocating their investors’ capital.

By calculating  a company’s return on invested capital, investors can get a better gauge of companies that do the best job investing their capital. Yet, ROIC is by no means the only metric that investors should use to buy stocks.

References:

  1. https://www.suredividend.com/high-roic-stocks/#top
  2. https://www.discoverci.com/stock-scanner/roic-screener

Margin of Safety

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“A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world.” ~ Seth Klarman

Berkshire Hathaway CEO and Chairman, Warren Buffett, is known for his value investing approach, which involves finding companies that are undervalued by the market and investing in them for the long term. To invest like Warren Buffett, there are a few things you need to know.

  • First, you need to have a clear understanding of what value investing is and how it works.
  • Second, you need to be patient and be willing to hold onto your investments for the long term.
  • Third, you need to have the discipline to stick to your investing strategy even when the market is going against you.

When deciding on how to invest in a company, the first step is to determine its worth or intrinsic value. According to Warren Buffett, the best companies to buy are those that are inexpensive to buy. His investment strategy is based on a few simple principles:

  • Buy quality companies that have a competitive advantage (moat),
  • Buy them at a reasonable price with a margin of safety, and
  • Hold them for the long term.

These principles of margin of safety have helped Buffett generate incredible returns over his career. Margin of safety is a strategy that involves investing only in securities at a significantly lower intrinsic value than their market price.

The margin of safety (MOS) allows investors to avoid overpaying for an investment or asset, and it protects investors from the potential of loss if the market price of the asset falls. Buffett has said that the margin of safety is the key to his investing success.

The margin of safety is a measure of how much room there is between the price of the stock and its inherent value. The wider your margin of safety, the less likely it is that overly optimistic valuation inputs will harm your investment.

Value investing is the process of making investment decisions using margin of safety. It is critical for value investors to find a high-quality, easy-to-understand company with good management priced below its intrinsic value.

The purpose of using a margin of safety in buying is twofold.

  • If your investment does not grow as quickly as you originally anticipated, you may be forced to make more conservative investments in your portfolio. If your estimates are correct, you will be able to achieve a better rate of return over time due.
  • If you purchased the investment at an extremely low price.

Discounted cash flow (DCF) is a method of valuing a company or asset using the principles of time value of money.

The objective of DCF is to find the value of an investment today, given its expected cash flows in the future. One popular way to value a company is using the discounted cash flow (DCF) method. This approach discounts a company’s future expected cash flows back to the present day, using a required rate of return or “hurdle rate” as the discount rate. The idea is that a company is worth the sum of all its future cash flows, discounted back to the present.

The DCF formula is: Value of Investment = Sum of (Cash Flow in Year / (1 + Discount Rate)^Year)

The “discount rate” is the required rate of return that an investor demands for investing in a company. This rate is also known as the “hurdle rate.” There are two ways to calculate the discount rate.

There are two ways to calculate the discount rate.

The first is the weighted average cost of capital (WACC). This approach considers the cost of all the different types of capital that a company has, including debt and equity.

The second way to calculate the discount rate is the discount rate for equity. This approach only considers the cost of equity, which is the return that investors demand for investing in a company.

Once the discount rate is determined, the next step is to estimate the cash flows that a company is expected to generate in the future. These cash flows can come from a variety of sources, including operating income, investments, and financing activities. After the cash flows have been estimated, they need to be discounted back to the present using the discount rate.

The present value of the cash flows is then the sum of all the future cash flows, discounted back to the present.

“If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you’d need. If you’re driving a truck across a bridge that says it holds 10,000 pounds and you’ve got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay, but if it’s over the Grand Canyon, you may want a little larger margin of safety.” ~ Warren Buffett

References:

  1. https://www.merchantshares.com/margin-of-safety-the-key-to-warren-buffetts-investing-success/
  2. https://www.merchantshares.com/the-dcf-method-of-valuing-a-company/
  3. https://www.merchantshares.com/how-to-win-warren-buffett-39/

Warren Buffett’s Investing Top Four

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“Don’t look at a stock like it is a ticker symbol with a price that goes up and down on a chart. It’s a slice of a company’s profits far into the future, and that’s how they need to be evaluated.” ~ Warren Buffett, Chairman and CEO, Berkshire Hathaway

Warren Buffett’s philosophy is simple. Buy with a “margin of safety” undervalued companies with strong fundamentals and balance sheet, and then wait. It’s possibly the most boring way to invest in the world. But it’s effective.

For Warren Buffett, deciding what stocks to buy is “simple but not necessarily easy,” according to CNBC Warren Buffett Guide to Investing.

In his Berkshire Hathaway 1977 annual letter to shareholders, he listed four attributes he wanted to see when investing, whether he’s buying the entire company for Berkshire, or just a slice of it as a stock.

1. “One that we can understand…”

When Buffett talks about “understanding” a company, he means he understands how that company will be able to make money far into the future.

He’s often said he didn’t buy shares of what turned out to be very successful tech companies like Google and Microsoft because he didn’t understand them. At the 2000 annual meeting, a skeptical shareholder told Buffett he couldn’t imagine him not understanding something. Buffett responded, “Oh, we understand the product. We understand what it does for people. We just don’t know the economics of it 10 years from now.”

2. “With favorable long-term prospects …”

Buffett often refers to a company’s sustainable competitive advantage, something he calls a “moat.”

“Every business that we look at we think of as an economic castle… And you want the capitalistic system to work in a way that millions of people are out there with capital thinking about ways to take your castle away from you, and appropriate it for their own use. And then the question is, what kind of a moat do you have around that castle that protects it?”

— 2000 BERKSHIRE ANNUAL MEETING

A “moat” consists of things a company does to keep and gain loyal customers, such as low prices, quality products, proprietary technology, and, often, a well- known brand built through years of advertising, such as Coca-Cola. An established company in an industry that has large start-up costs that deter would be competitors can also have a moat.

3. “Operated by honest and competent people …”

“Generally, we like people who are candid. We can usually tell when somebody’s dancing around something, or where their — when the reports are essentially a little dishonest, or biased, or something.

And it’s just a lot easier to operate with people that are candid.

“And we like people who are smart, you know.

I don’t mean geniuses… And we like people who are focused on the business.” — 1995 BERKSHIRE ANNUAL MEETING

The quality of the business itself, however, takes precedence.

“The really great business is one that doesn’t require good management. I mean, that is a terrific business. And the poor business is one that can only succeed, or even survive, with great management.” — 1996 BERKSHIRE ANNUAL MEETING

4. “Available at a very attractive price.”

“The key to [Benjamin] Graham’s approach to investing is not thinking of stocks as stocks or part of a stock market. Stocks are part of a business. People in this room (Berkshire shareholders) own a piece of a business. If the business does well, they’re going to do all right as long as they don’t pay way too much to join into that business. — 1997 BERKSHIRE ANNUAL MEETING

Buffett’s goal is to buy with a “margin of safety” or when the market price is below a company’s “intrinsic value.” Buffett has said that the margin of safety is the “most important concept in investing.”

“The three most important words in investing are margin of safety…” ~ Warren Buffett

“The intrinsic value of any business, if you could foresee the future perfectly, is the present value of all cash that will be ever distributed for that business between now and judgment day.

“And we’re not perfect at estimating that, obviously.

“But that’s what an investment or a business is all about. You put money in, and you take money out.

“Aesop said, ‘A bird in the hand is worth two in the bush.’ Now, he said that around 600 B.C. or something like that, but that hasn’t been improved on very much by the business professors now.” — 2014 BERKSHIRE ANNUAL MEETING

References:

  1. https://fm.cnbc.com/applications/cnbc.com/resources/editorialfiles/2022/03/22/bwp22links.pdf

Focus, Discipline and Patience are Wealth Building Super Powers!

Intrinsic Value

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“Every investment is the present value of all future free cash flow.” Everything Money

Cash flow refers to the net amount of cash and cash equivalents that comes in and goes out of a company. Businesses take in money from sales as revenues and spend money on expenses. Cash received represents inflows, while money spent represents outflows.

“Intrinsic value can be defined simply as the discounted value of cash that can be taken out of a business during its remaining lifetime. “ ~ Warren Buffett

A company’s ability to create value for shareholders is fundamentally determined by its ability to generate positive cash flows or, more specifically, to maximize long-term free cash flow (FCF). FCF represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets.

Intrinsic value is defined as the discounted present value of all future cash flow of a business.

The only reason to lay out money for an investment now is to get more money later.  When you invest in a bond, its very easy to see the future cash flow and the terminal value of a bond, its printed on the certificate.

When you invest in a stock,

Investing in any financial asset involves laying out cash now in order to get cash later out of the investment.  And investing in a business, can the business deliver enough cash to you (the owner) soon enough that it makes sense to buy it as its current market value?

How much am I willing to pay for a business, considering it makes $24B in cash flow per year, and is growing at 10% annually.

Once we determine the business intrinsic value, we compare that number to the business’ current market capitalization.  Market cap is the product of the total shares outstanding and the current market stock price.

  • Market cap is higher than intrinsic value = overvalued
  • Market cap is lower than intrinsic value = undervalued

Discounted Free Cash Flow since one dollar today is worth more thant $1 in five years due to opportunity costs and lost of purchasing power of that dollar.

  • Step 1:  Find the current free cash flow – Free cash flow is the amount of money left over for the owners of the business, after factoring in cash outflows that support its operations and maintain its capital assets. The ideal FCF for valuation would equal Operating Cash Flow minu Maintenance CapEx
  • Step 2:  Grow the current free cash flow out 10 years in the future – the growth rate used will have a big impact on the final intrinsic value calculation. Check historical growth rate for cash flow and industry growth rate for cash flow.  Or, look at trend and future capital investments.
  • Step 3:  Add a terminal value – what you can sell the business for in 10 years.  Use FCF multiple.
  • Step 4:  Discount all future cash flows to present value at a rate of 12% to 15%
  • Step 5:  Add together all future cash flows to find intrinsic value
  • Step 6:  Add a margin of safety (of 20% to 30%)

In the current market environment, most companies will be trading above the intrinsic value.

References:

  1. https://www.investopedia.com/terms/f/freecashflow.asp

Value Investing

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Value investing involves determining the intrinsic value — the true, inherent worth of an asset — and buying it at a level that represents a substantial discount to that price.

The gap between a stock’s intrinsic value and the price it is currently selling for is known as the margin of safety.

The greater the margin of safety, the more an investor’s projections can be off while still profitably gaining from an investment in the shares of the company being evaluated.

It can be helpful to ensure you understand what value investing is and is not. It is not searching for stocks with low price-to-earnings ratios and blindly buying the stocks that make that first cut. Instead, value investors employ a series of metrics and ratios to help them determine a stock’s intrinsic value and a sufficient margin of safety.

Value investing in stocks often means looking for mispriced shares in out-of-the-way places. This can include looking at companies in out-of-favor sectors, businesses in frowned-upon industries, companies that are going through some type of scandal, or stocks currently enduring a bear market. Unpopular sectors and companies are often treasure troves for the successful value investor, requiring the possession of both a long-term approach and a contrarian mindset. Regardless of where the investments come from, though, value investing is the art and science of identifying stocks priced below their actual worth.

Successful value investing exercise patience and hold during lean times. Taking just one example, in early 2015, American Express shareholders learned that AmEx lost its exclusive credit-card deal with Costco Wholesale locations. In the following months, Amex lost almost 50% of its market-cap value. Yet far from being a moment to panic, savvy investors might have seen an opportunity to buy AmEx for outsized gains. Within three years of its lowest point, American Express had almost doubled and reached new all-time highs.

Selling at lows while negative sentiment is at its highest will guarantee frustration and permanent loss of capital. It can be hard to wait while your thesis plays out, but patience is absolutely necessary for value investors who want to beat the market.

Of course, value investing is more than a waiting game. Investors must remain diligent in staying up to date on a company to ensure their thesis is proceeding as planned. This means paying attention to the company’s business performance — not its stock price.

The Big 5 Numbers 

Phil Town, founder and CEO of Rule #1 Investing, says there are “the big 5 numbers” in value investing.

The Big 5 numbers are:

  1. Return on Invested Capital (ROIC)
  2. Equity (Book Value) Growth
  3. Earnings per Share (EPS) Growth 
  4. Sales (Revenue) Growth
  5. Cash Growth

All the big 5 numbers will be 10% or greater if the company, and he numbers should be stable or growing over the past 10 years. 

The big takeaway

Value investing is not easy. It requires time, focus, discipline, patience and dedication to the craft. It will often mean looking and feeling foolish while you wait for an investment thesis to play out. If this doesn’t sound like it’s for you, investing in passive index funds is a perfectly suitable alternative.

For investors who enjoy the hunt of looking for undervalued assets — and beating the market at its own game — value investing can be richly rewarding in more ways than one. By following this simple guide, investors can be well on their way to understanding how value investing can beat the market.

References:

  1. https://www.foxbusiness.com/markets/how-to-be-a-successful-value-investor
  2. https://wp.ruleoneinvesting.com/blog/how-to-invest/value-investing/
  3. https://valueinvestoracademy.com/i-read-rule-1-by-phil-town-heres-what-i-learned/